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The Case Against Small Caps

What you should know before you start messing with small stocks.

Remember the Wahoo who bet the farm on Yahoo!(NASDAQ:YHOO) back in 1996 and retired five years later? No, wait. That may have been a movie. (Was it Frequency?)

Anyway, that movie cuts both ways, right? After all, what about the less-fortunate chumps who get wiped out when the raging bull hits the fan, and their hot tip goes belly-up?

Isn't that the "problem" with buying small, lesser-known stocks, after all? That they're a crapshoot?

Well, you're smart to think that wayGo to Harvard Business School and they'll tell you the same thing. Be sure to pack a few hundred grand in small bills, though. Or save yourself some money and consider something else. What if the major malfunction isn't with small-cap stocks, but with small-cap investors?

What if the problem with small caps is that they attract the wrong crowd? Maybe all those gamblers and daredevils, vying for the next home run, create the "illusion" of a wacky and treacherous market.

Don't take my word for it -- reams of data support that contention. But here's something more important than any piece of data: how you can use this "illusion" to make money.

Why small-cap investors get creamedYour finance professor can tell you why small caps are "risky." Markets are illiquid, for one thing. Earnings are lumpy and less dependable. Capital is costly and hard to come by, especially when times get tough.

All true, but I'm not convinced that's why so many small-cap investors lose their shirts. It's more insidious than that. It's because they don't invest. They speculate on stock tips and high-risk story stocks with low-quality -- or worse, no -- real earnings. It's that simple.

Small-cap investors -- too many, at least -- ignore fundamentals. If you don't believe me, ask yourself this: When was the last time you heard some guy at a party or on TV pumping a small, unknown company, and he wasn't focused entirely on the story? Hardly ever, right?

Then again, who wants a cigar butt?Now, compare that with the stodgy old-timers who fuss over mature large-cap, cigar-butt-and-smokestack companies trading at bargain prices. Could these guys be more boring? They never talk story or potential. They're all hidden assets, cash flows, and valuation.

That's why they don't earn their full potential, either. They're too busy picking over Wall Street's scrap heap. You can make money on fallen angels like Washington Mutual (NYSE:WM) or SLM (NYSE:SLM), but even if you do call the bottom, their triples and quadruples are behind them. They're still too big.

The same goes for cash-heavy techs -- Microsoft (NASDAQ:MSFT) and Oracle, for instance. What if we took the old-school valuation techniques made famous by Ben Graham and Warren Buffett and applied them to smaller companies whose growth spurts are still ahead of them? Again, I know it sounds simple, but you'd be amazed at how few investors even give it a shot.

Forget "the next home run stock"If you're a regular here, you know about my run-ins with Motley Fool co-founder Tom Gardner. Along with people such as Chuck Royce and David Nierenberg (whom we had the pleasure of meeting here at Fool HQ recently), Tom and his crew at Motley Fool Hidden Gems are among the few I've seen who successfully cash in on this little "trick."

The trick, of course, is shunning "the next big thing" and buying small businesses with strong fundamentals that are selling at good prices -- in other words, small-cap value. The guys I just mentioned make money in small caps by balancing the fun stuff -- "story" and "potential" -- with old-fashioned fundamentals and valuation.

Tom never tires of explaining that this is precisely what led investors to Wal-Mart in the '70s, and how they turned a $5,000 investment into millions. What was so great about Sam Walton's general store back in 1975? A few things.

Follow the moneyFor starters, Wal-Mart was rapidly expanding revenues and profits, even back in 1975. That's clearly not the case with too many of today's hot story stocks. Which isn't to say they don't have potential. The problem is they are all "potential."

Speculating on companies like these may work out for you, but it may not. Investors got a 20% pop last week on CDC (NASDAQ:CHINA), a stock that's unpopular on Wall Street but liked by Fool readers.

The big news? Company-promoted insider buying, of all things. As a longtime holder of embattled ImClone (NASDAQ:IMCL), a poster-child for insider shenanigans, I can attest that this kind of "non news" can knock a thinly traded story stock down as well as up.

Which is not to say you should never take a flier. But balance is key. The safer play, I think, is to dig up small caps like Wal-Mart -- when they're still small but making money -- that can make you a lot of money methodically over the years.

After all, this "trick" turned $1,000 into $33 million
Granted, it took nearly 70 years to do it, but according to Ibbotson Associates, if you'd invested $1,000 in small-cap value stocks back in 1927, you'd have more than $33 million by now.

That's three times as much as you'd have if you'd invested in a broad basket of small caps, and more than 15 times better than if you'd bought large caps instead. Will those numbers hold up? Well, Tom Gardner has been mining small-cap value at Hidden Gems for just a couple of years now, but judge for yourself.

So far, Tom has alerted his subscribers to dozens of small-cap value stocks. More than a 20 subsequently doubled or more, and as of this morning, the entire portfolio is up 44.1% on average per pick. That's more than double the respectable 19.2% return of the S&P 500.

How about some really good news?
You don't have to pay Harvard to find great small-cap values anymore. You can buy Ben Graham's Security Analysis at any bookstore -- if you're up for flipping through 700 pages, that is. But there may be an even easier way -- with no heavy reading or speculation required.

You can join Tom Gardner at Hidden Gems free for 30 days. Check out the complete Hidden Gems service for a full month, including all of Tom's recommendations and every newsletter issue and special report he's ever published. Then take a whole month to decide whether you want to sign up.

I guarantee that you'll meet lots of friendly and knowledgeable folks, and nobody will pressure you to subscribe. Best of all, the first lesson ... and his top five picks for new money right now ... is always on Tom. To take advantage of this special free trial, click here.

This article was originally published on Feb. 17, 2006. It has been updated.

Fool writer Paul Elliott promises to keep you posted on Tom Gardner's progress at Hidden Gems (yes, through good times and bad). You can view all picks immediately on Tom's scorecard with your free trial. Paul owns shares of ImClone. Wal-Mart and Microsoft are Motley Fool Inside Value recommendations. Yahoo! is a Stock Advisor pick. Washington Mutual is an Income Investor selection. The Motley Fool has a disclosure policy.